Yen surges after hedge fund warning

The Japanese yen surged on markets after top Asian and European officials warned that "carry trade" speculation by hedge funds had pushed the currency far below its natural value, increasing the risk of a sudden rebound that could destabilise world markets.

Haruhiko Kuroda, president of the Asian Development Bank, said the practice of borrowing at near-zero interest rates in Japan to invest in bonds, stocks and property across the globe was stretched to breaking point.

"The yen weakness from yen carry trade has gone too far. If it starts to unwind the whole process will be reversed," he said at the World Economic Forum in Davos.

Funds have continued to play a game of "chicken" with the Japanese currency, tempted by the continued yield gap between Japan - where rates are still just 0.25pc - and double-digit rates in places like Iceland.

They count on being nimble enough to liquidate their positions fast as soon as Japan begins to tighten monetary policy, but the scale of the trade is so vast that not all investors could squeeze through the narrow exits at the same time.

The carry trade made sense when Japan was still trapped in a deflationary slump, but Mr Kuroda said the recovery was now firmly on track. "The Japanese economy has been growing at around 2pc and the problem of corporate bad loans has been solved," he said.

The comments came a day after the yen tumbled to a record low of 158.60 against the euro, prompting growing concern among eurozone officials.

Germany's deputy finance minister Bernd Pfaffenbach said in Davos that the dramatic slide in the yen over recent months had reached the moment the politicians would have to intervene. "The yen's lasting weakness is a cause for concern to us. I assume we will address the weakness again on the sidelines of the G8," he said.

The yen surged to 155.79 against the euro and 120.21 against the dollar as the comments hit traders' screens.

"This had quite an impact on the markets today," David Bloom, chief currency strategist at HSBC.

"Nobody knows how big the carry trade really is and that causes fear. But if the politicians now start meddling with this beast they'll unleash forces that can't be controlled," he said.

Japan has a current account surplus of 3.8pc of GDP and its citizens hold net assets abroad of around $2.5 trillion. Once speculators switch to the other side of the trade, there may be no stopping the yen.

Miyako Suda, a Bank of Japan governor, added to hedge fund fears with a warning that Tokyo would soon be turning off the tap of cheap credit. ''If we spend too long in examining data, a rate increase would be too late and could cause a risk that the bank will have to hasten the pace of rate increases later," he said.

The central bank has begun monitoring the carry trade movements, keeping a close eye on the billions of dollars of hot money that can shift direction in an instant.

Tokyo is concerned that a violent surge could play havoc with the Japanese economy as it did in 1998 when panic unwinding caused the yen to strengthen from 145 to the dollar to 115 in a matter of weeks.

The chain reaction was a key reason why the US hedge fund Long Term Capital Management suddenly found itself in debt to the tune of $100bn in September 1998, prompting the US Federal Reserve to push through three emergency rate cuts after the New York banking system to "seized up".

It is unclear whether a similar crisis could occur now, but veteran market watchers say the yen carry trade - and the possibility of a "short squeeze" in the derivatives markets - remains the single most dangerous threat in the global system.